Wednesday, March 17, 2010

The Producer Price Index dropped -0.6% in February, mainly because oil prices fell. Core prices were up 0.1%. Year over year, both are in positive territory; we might say that inflation at the producer level is somewhere between 1% and 5%.

Nevertheless, it's hard to get a grasp on what is happening, with all the gyrations of late. So I put together the following chart which shows the Producer Price Index from 1960 through Feb. '10. (Note how prices have risen fully 640% over this period!! Just a little bit of inflation every year can really add up.)

I've identified 5 different inflationary periods on the chart, with the annualized rate of inflation noted for each. It begins with the wonderful years in the early 1960s when inflation was basically nonexistent. From '66 through '73 we had inflation that resulted from massive government spending programs that the Fed felt obliged to monetize to some degree. Then from '74 through '82 we had the calamitous inflation that resulted from a massive devaluation of the dollar and a Fed that could never tighten enough. From '83 through '03 we enjoyed relatively low and stable inflation thanks to Volcker's bold monetary tightening in the early '80s, and Greenspan's able stewardship of the Volcker legacy. From '04 on, we've had mostly easy policy from Greenspan and Bernanke.

Inflation in the past six years has averaged about twice what it did from '83 through '03, and to judge from the Fed's super-accommodative policy stance, inflation threatens to move even higher. At the very least this chart reminds us that Fed policy does make a difference. It is not unreasonable to expect inflation to be 3% or more in coming years, regardless of how weak the economy is and how much economic slack exists. Bernanke & Co. are stuck in their Phillips Curve rut, much like the Fed was stuck in the 1970s; always thinking that a weak economy would keep easy money from being inflationary. It didn't work then and it's not likely to work now. Very unfortunately for all of us who believe that low and stable inflation is a precondition to prosperity.

28 comments:

Jeez, the core rate of inflation looks dead to me--and we are currently enjoying huge growth in output per worker, and very soft commercial rents for all sorts of space, be it retail, office or warehouse (not so nejoyable for property owners).

I look at the redline on the chart, and I just can't get scared about inflation--especially now, when every producer is hungry for sales. Demand-pull inflation does not seem to be in the cards.

There is near global competition for many sales.

I hope Bernanke runs the printing plants until they melt, and then flys over the USA with a fleet of 747's, sprinking c-notes the whole way. That's how unafraid I am of inflation.

Wouldn't you say a big part of inflation over the past 30 years has been borrowing more and more money?

In 1980 America had a total of about $5 trillion in public and private debt vs. today we have about $55 trillion.

As long as we kept borrowing our economy grew and inflation marched right along....and since private borrowing is drying up, government has made up the difference as of late by borrowing at a unprecedented rate of $2 trillion dollars per year,

Without government borrowing and spending right now, consumption in our economy would implode as fewer and fewer have access or desire to borrow and/or spend.

Borrowing and spending two trillion is an incredible stimulous, especially if you factor the mulitiplier effect....especially as it relates to inflation....yet we are stumbling along with very low rates.

Could you imagine how our economy would implode if government didn't borrow $2 trillion and actually spend it?

As you know the federal reserve has a duel mandate to balance inflation with 'full' employment. With unemployment the highest since the early 1980s and current inflation running very low I can't swallow the inflationist's argument that rates need to be hiked. Sorry, but I just can't keep it down. It is inevitible that rates will need to go up but with unemployment so high I can't see it happening soon. I have been seeking some historical data on the time differentials between peak unemployment and initial fed rate hikes in past cycles, particularly the early 1990s and 2000s. Past fed behavior may give us a clue as to when the first rate hikes may come.

As always, I enjoy your blog so much. Many thanks for your efforts. They are greatly appreciated.

But if you borrow every dime(plus a few quarters that don't exist) of savings and advance demand decades causing prices(common man application of inflation)to rise.....what happens when savings runs out???

If printing money is the answer....then don't we enter a dangerous zone of the technical definition of inflation?

I learned in grad school that leverage works both ways, and that banks can create a loan for $1000 for every $100 received in deposits. Isn't it a meme that when banks begin loaning again, inflation will take off? Please correct me if I'm wrong. Thanks!

Redbud: Banks create money by acquiring reserves. The Fed has pumped in an additional $1.25 trillion in reserves, but almost all of those reserves are sitting idle. Either banks don't want to lend, or loan demand is weak, or both. The great fear is that if banks do start lending again in a serious way, they will have a virtually unlimited capacity to create money, and that will surely drive inflation higher. At this point we can only hope the Fed will react in time and withdraw the extra reserves.

Lots of confusion on how money works in the economy -- how it is created and destroyed by the Fed. It takes some serious thinking to realize that the Fed alone causes inflation by printing more money than the economy needs.... and as for feeling like no inflation, let me tell you... as someone who is on a fixed income, that the 3.5%/yr that we have been experiencing hurts badly, not in one year but over several.

you cant borrow quarters that dont exist unless you print them (or mint them in your example), thus inflation. The Fed can print dollars and then the Treasury can borrow them, hence inflation through debt.

Excellent points. But credit and money spend exactly the same and to the retailer it is a distinction without a difference.

The problem is when you extend too much credit to an economy, and there is not enough money to service it but for the extension of more credit......the result is a very dangerous one....either hyperinflation or a deflationary depression.

What few want to acknowledge right now is most of our retirement plans and investments are simply a matrix of defaulting debt that can't be serviced unless MASSIVE addtional credit is extended or more money printed.

You will understand this better in upcoming months as more and more debt defaults and more and more businesses go bankrupt while more and more citizens get fired driving less and less tax receipts to government.

For the past ten years, we were simply a credit driven consumer based economy...and without credit being extended to the consumer, we really don't have much of an economy. It really is pretty simple if you think about it. However most people have a 30 year time frame, just about Madoff's tenure.

“Bernanke & Co. are stuck in their Phillips Curve rut, much like the Fed was stuck in the 1970s; always thinking that a weak economy would keep easy money from being inflationary.”

Personally think this is the most important part of your article. Just happened to be at university during the 1970’s and we studied the Phillips Curve in great detail. The Phillips Curve got “busted” as a theory when stagflation came along. Suddenly the trade-off between unemployment and inflation as predicted by the Phillips Curve no longer worked. The idea that high inflation was a tolerable event since it created high employment was no longer valid (if it was ever a valid concept to begin with).

There was a great deal of public policy based on the Phillips Curve through out the 1960’s right into the 1970’s. Keynesians were still stating the Phillips Curve was valid right into the late 1970’s.

However, the Phillips Curve just will not die. Neo-Keynesians and New Keynesians keep trying to patch-up the Phillips Curve and state its still valid. The Federal Reserve Bank of Richmond, Economic Quarterly, Volume 94, Number 4, Fall 2008 devoted a special issue (the entire issue) to: “A special Issue on the Phillips Curve and its Implications for Modern Monetary Policy”. The issue explains macroeconomic policy based on the Phillips Curve 1958-1996 then goes into great detail and analysis of the New Keynesian Phillips Curve.

Was lucky enough to be at a university in the 1970’s with a ton’s of Milton Friedman type professors and a bunch of economics professors on loan from Germany in an exchange deal. Those German professors loved to disprove Keynes. They had a field day with the Phillips Curve.

PacificAllen: Thanks for the correction. The Fed is indeed the source of money creation. Banks can be thought of as the conduit for money to enter the economy.

There is such widespread confusion over the differences between credit, monetary expansion and inflation that I am amazed. I suppose this helps make the market inefficient, and that in turn allows those who do understand how things work to have an edge.

Crickey!Will you guys look at the chart?It shows PPI under 4 percent for 20 years, despite continual handwringing from many that our monetary policy was too loose.Now, the PPI is flat Y-O-Y and was below zero on average for all of 2009. We had deflation last year, and are flatlining.

We have huge recent increases in output per worker hour, and a glut of commercial space, coast to coast.

We have problems galore in our economic management, and, in general, I support a supply-side approach.

But inflation causes me no worries.

And even some inflation might be good--I see little, if any, evidence either party can balance the federal budget. We need to pay down debt somehow, and inflation is about the only realistic way I see.

WEH: The Phillips Curve and Keynesian economic theory both refuse to die, and they continue to wreak havoc on the world's economies. Sadly, economics is not a science, and even if it were, it's politicians that get to pull the policy levers.

I don’t have near the expertise of Scott and apparently many of the others in this thread. However, I believe that there is a major tug-of-war between globalization driving deflation, and massive monetary expansion (driving inflation) intended to offset the declining real income due to globalization. Though the trend inflation rate may seem benign, the tug of war has greatly increased the tension and the risk of critical disruption one way or the other. In the end, it doesn’t seem likely that we can borrow our way to prosperity. I fear we are in for continuing cycles of leverage driven asset bubbles, and subsequent busts.

( i shouldn't try to write this and watch 24 tivo at the same time...)

randy: You're letting yourself get confused. Inflation is a monetary phenomenon that is completely dependent on the Fed. Globalization has been underway for hundreds of years, and has not stopped inflation from happening everywhere. Whatever deflationary forces may be coming from overseas can and should be dealt with by the Fed.

In any event, I would argue that the enemies of globalization are among those who would urge the Chinese to revalue the yuan. That would mean a weaker dollar, and a weaker dollar can only add to inflationary pressures.

To clarify, monetary inflation is the fed creating money, and price inflation comes when the money enters the economy, right? So when banks create loans, and those funds are spent, doesn't that add to the money in circulation and price inflation?

To begin with, the Fed buys some asset, typically a T-bond, and pays for it by crediting a bank's account with reserves. So far no money has been created; the Fed owns more bonds, and banks have more reserves as assets. Then along comes Mr. X who wants a loan from the bank. Since the bank has just received a shot of reserves from the Fed, it is able to use those reserves to create money which is deposited in Mr. X's account. Banks must always hold about 1 dollar in reserves for every dollar on deposit. Mr. X signs a document saying he owes the bank the sum of money that the bank has deposited in his account. Mr. X then spends the money, and the money enters into circulation.

Inflation happens if the Fed's willingness to supply reserves to banks, and the public's willingness to borrow against those reserves, results in an addition of money to the economy that is greater than the economy's willingness to hold money.

17% unemployment does not equate to a large amount of slack in the economy because there are no jobs for most of these people to go back to. The unemployed have the wrong skills (construction), they live in the wrong places (California), potential employers are spooked by the micro-econonmic policies of the Obama administration, both implemented and threatened. and the level of benefits to the unemployed reduces incentives to work for part of the labor force.

Growth cannot come from residential construction or finance or government services or increased consumption. It can only come from capital investment, exports and import substitution. In short, the way forward does not take us back to 2006.

This is why expansionary monetary policy only stokes the fires of inflation. Obama has put a heavy foot on the brake pedal and is busy shifting into neutral. Revving the engine does no good.

As for inflation, the cost of the things I buy continues to increase at about a 3-4% annual rate. I see no reduction in the cost of services that I consume personally and government-driven inflation in the cost of health care and public schooling continues unabated.

Some folks tend to get all "technical" about the definition of inflation, so allow me to cut to the chase and identify "inflation" from my perspective:

Inflation is when I have the roughly the same amount of money coming in week to week, month to month, but without adding to my bills, without "expanding" my "lifestyle," my money goes less far - I get less bang for the buck.

To me inflation is tied to lifestyle as well as fixed costs. When it costs me $2/gal to fill my tank I'm a happy fellow. $2.50/gal. not so happy. $3.00/gal. unhappy. $3.50/gal. I'm really sweating... my "pocket money" is really taking a hit. $4.00/gal. and ordering a pizza on Friday night or going to a movie on Saturday night is a real splurge.

Get what I'm saying...?

To me inflation is when I was going down the beer isle at the supermarket the other day and I noticed a six-pack of Bass Ale was priced at $9.99 when a not so long ago I could often pick up a 12-pack for $12.99 - sometimes $11.99.

Inflation is going to the deli counter and the roast beef that a few short years ago was regularly $4.99/lb. (and sale priced as low as $2.99/lb. at times) is now regularly $9.99/lb. and trending up to a new "regular" price of $10.99/lb. or even $11.99/lb.

Garden State Parkway tolls going from .35-cents to .70-cents is inflation. The "prime time" George Washington Bridge toll going to $8 - even with EZPass - from $5 a year or so ago is inflation.

Tuna going from a 6 oz. can to a 5 oz. (but the latest of package downsizings) is to me a 20% price increase. Tuna aside... the same thing - product downsizing - is happening all across the packaged food sector. Coffee cans used to be 1 lb cans... then 14 oz. cans... the 13 oz., then 12 oz., and now 11 oz. cans are the norm.

Taxes... fees... "surcharges"... up, up, up...

Trying to charge me $10/$12 a day to use the hotel pool - WHEN I'M STAYING AT THE HOTEL - as this sort of thing becomes more and more common that's a type of "inflation" in the "big picture" sense of the word.

Anyway... everything depends upon what happens with oil prices this year. If oil prices spike up to $90/barrel. for a few months that's not a "symptom" of inflation - that's going to be a cause of inflation. If (when) oil shoots up to $150/barrel... that will usher in what amounts to hyperinflation.

(No... not wheelbarrels of hundred dollar bills to buy a loaf of bread, but more than enough inflation to really screw those of fixed incomes!)

In any case... I see stagflation (at best!) as our immediate and mid-term economic future.

Hello. Would you please comment on the following, from "George Washington" as posted on Zero Hedge? .

"Private banks don't make loans because they have extra deposits lying around. The process is the exact opposite:

(1) Each private bank "creates" loans out of thin air by entering into binding loan commitments with borrowers (of course, corresponding liabilities are created on their books at the same time. But see below); then

(2) If the bank doesn't have the required level of reserves, it simply borrows them after the fact from the central bank (or from another bank);

(3) The central bank, in turn, creates the money which it lends to the private banks out of thin air.It's not just Bernanke ... the central banks and their owners - the private commercial banks - have been running the printing presses for hundreds of years.

Of course, as I pointed out Tuesday, Bernanke is pushing to eliminate all reserve requirements in the U.S. If Bernanke has his way, American banks won't even have to borrow from the Fed or other banks after the fact to have reserves. Instead, they can just enter into as many loans as they want and create endless money out of thin air (within Basel I and Basel II's capital requirements - but since governments keep overtly and covertly throwing bailout money, guarantees and various insider opportunities at the giant banks, capital requirements are somewhat meaningless).

The system is no longer based on assets (and remember that the giant banks have repeatedly become insolvent) It is based on creating new debts, and then backfilling from there.

It is - in fact - a monopoly system. Specifically, only private banks and their wholly-owned central banks can run printing presses. Governments and people do not have access to the printing presses (with some limited exceptions, like North Dakota), and thus have to pay the monopolists to run them (in the form of interest on the loans)." ...

"At the very least, the system must be changed so that it is not - by definition - perched atop a mountain of debt, and the monetary base must be maintained by an authority that is accountable to the people."

Redbud: The description of how money is created is basically right but I would disagree with some of the nuances. The Fed creates reserves "out of thin air" by buying assets such as Treasury bonds or MBS. Reserves become the liability of the Fed, and there are always assets to back them up. Banks must hold reserves to back up their deposits. The Fed sets a target rate for reserves (the Fed funds rate). If banks want more reserves than are available, the Fed supplies extra reserves in order to keep the overnight funds rate at the target. Ultimately, the Fed tries to set the target rate at a level which will result in an amount of money (deposits) just sufficient to match the demand for money, thus not being inflationary. But the Fed can and does (often) pick the wrong rate, and the result is either too much money or not enough (mostly too much, which is why we have almost always had inflation).

The system is always under the control of the Fed. In theory, banks could lend without limit, but in practice, that is not the case because the Fed would see excessive demand for reserves and raise the rate on reserves until the demand fell.